Were Momentum, Small Caps the 'Canaries' for Stocks?

Small caps and momentum stocks may have been flashing warning signs about a broader market pull back.

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New York Stock Exchange trader

Today, the broader market joined the selling, with the Dow and S&P down more than 1 percent and Nasdaq down more than 2 percent. The Dow has not been down more than 1 percent since Nov. 23. At the same time, the market fear meter, the CBOE's Vix, jumped more than 19 percent.

"I believe that we're going to see this continue for the month," said Marc Pado, U.S. strategist and technical analyst at Cantor Fitzgerald. "This is the beginning of a corrective phase. It's not all negative that we're seeing a pull back phase. The S&P was up 25 percent, at 1300, since the first day of September. That's a heck of a run and it's overdue for a pull back."

He expects a shallow 5 to 7 percent pull back, but more in high beta names, which have already been under pressure. Traders have been rotating into safer big cap names. Pado also said signs of a pending pull back were apparent last week when the Russell 2000 indexlost more than three percent in two days. At the same time, the Dow was making new highs, signaling a divergence.

"You don't typically get a correction before you see a divergence. That's the divergence we were looking for that set us up for the pull back phase," said Pado.

Traders have been watching some of their favorite—maybe now former favorite—stocks get kicked well before today's sell off. Look at F5. It was hot, and it was even added to the S&P 500. Then its earnings disappointed and now its chart looks downright ugly. But it's not alone.

""The trade changed from the momentum breakout to a lot of them getting punished," said Scott Redler of T3Live.com. "Look at Amazon. As of this point in the rally, you really had to say really good things with really good guidance to have huge moves (higher), and all these high beta tech stocks had had huge moves up and they were priced for perfection." Amazon was down sharply on disappointing earnings news.

Redler pointed to Google and Apple, two favorites, and both are getting smacked hard today. "It's a time to be very light," he said. Redler, who follows the market's short term technicals, said he cashed out and is currently flat.

"Momentum stocks, I think they're just the higher beta stocks that tend to be a lot more the riskier stocks," Pado said. "The idea is they were leadership on the way up. Obviously investors are willing to take risk when they're more bullish. When they hide in big cap stocks, they're a little bit less willing. They need the liquidity and they need to be able to get out quick."

Deutsche Bank's chief U.S. equities strategist Binky Chadha said a January correction in momentum and growth names is not uncommon.

"December is a a very reaffirming time and January is a very confusing time," Chadha said. "...There's a tendency for people to dress up their portfolios and people like to show they held some of the best stocks on their books (at year end). There's a tendency for momentum to outperform in December and then to undo that December effect in January."